Written by: George Shirley Opinions are those of George Shirley and not necessarily RJFS or Raymond James
When evaluating a portfolio, most investors understand the concept of diversification. What is less understood-- and can have a bigger impact on a portfolio performance and volatility-- is correlation.
Correlation attempts to quantify the price movement of two securities as related to one another. Assets that are positively correlated move in the same direction; assets with negative correlation move in the opposite direction.
We spend a significant amount of time evaluating the correlation in a portfolio when attempting to quantify the risk and in deciding which investments to add or reduce. While it may be counter-intuitive, having a portion of the portfolio that goes down or sideways in a rising market, is critical to creating a broadly diversified portfolio that can withstand market swings.
Consider a number of businesses at a beach. One sells Ice cream, one sells sunscreen, one sells raincoats. All of these business would be impacted by the weather, but the ice cream and sunscreen businesses would expect to receive more business on warm sunny days, whereas the raincoat business would generate more business on rainy days.
The correlation between the ice cream and sunscreen business would be positive; the correlation between ice cream business and the raincoat business would be much lower, if not negative. In investment terms, a portfolio of the ice cream and the sunscreen business would be much more correlated than a portfolio of the ice cream and raincoat business.
If you already own shares of the ice cream business, adding the sunscreen business would likely not change the overall trajectory of the portfolio during an extended period of rain. And while you may want to have more exposure to businesses that perform well in sunny weather, the % that you allocate to the raincoat business would likely lower the overall bad weather-related risk to your portfolio.
In the example of the beach businesses, you don’t hope for rain, but you prepare for it and aim to limit your downside in the event of a long spell of rainy weather.
When considering how your investments are allocated, be sure to consider the correlation between the assets that you own.
Diversification and asset allocation do not ensure a profit or guarantee against loss. Investing involves risk, investors may incur a profit or loss regardless of the strategy or strategies employed.